Short sales and tax consequences – analysis of a “normal” sale

Regardless of where you live in Washington state—whether you call Federal Way, Bremerton, Tacoma, Renton, Auburn, Tukwila,  Lakewood, University Place, Puyallup, or Olympia home—you must be aware of potential tax consequences of a “short sale” or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether or not you will have taxable income on your personal residence after foreclosure.

Please note that this analysis is limited to your personal residence in which you have lived for at least two years.

The NCLC (National Consumer Law Center) publication entitled “Foreclosure Prevention Counseling”, 2009 edition, Chapter 9, pages 147-152, covers this subject well. This publication is available for $60.00 at www.consumerlaw.org.

For example, Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, page 149.

To understand the problem of Discharge of Indebtedness Income/taxable debt forgiveness income, let’s examine a normal (non distress) transaction to determine whether the transaction does or does not result in taxable income.

Example #1 from the NCLC:

$100,000 purchase price of home
+ $30,000 add: improvements (new deck, addition, etc.)
= $130,000 new basis

$160,000 sale price
– $9,000 less: sales expenses
= $151,000 net sale price

$21,000 capital gain
$250,000 capital gain exclusion

$0 taxable gain
$0 taxable gain tax to be paid

Example #2 – single homeowner

$20,000 purchase price
+ $30,000 certain improvements
= $50,000 new basis

$600,000 sale price
– $40,000 less: sales expenses
= $560,000 net sales price

$510,000 capital gain ($560,000 – $50,000 = $510,000)
– $250,000 capital gain exclusion
= $260,000 taxable gain

$39,000 capital gains tax payable $260k x .15 tax rate = $39,000; assuming 15% tax rate on long-term capital gain)

The previous examples contemplate a “normal” sale–not a short sale or foreclosure.

In a future post, I will provide some examples of foreclosure/short sale operation.

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